Macroeconomics

Lecture Notes #3

TOPIC 3: BASIC KEYNESIAN MODELS

The Consumption Function

Consumption (C)- this is spending by households on goods and services.

The consumption function

The consumption function shows the relationship between total consumer expenditures and
total disposable income in the economy, holding all other determinants of consumer
spending constant.

Consumption is positively related to income (Y), that is, as Y increases, C increase. We can
say that C is dependent on Y or C is a function of Y written as C = f(Y).

The consumption function is therefore drawn as a straight line and has a constant slope.

See the diagram below:

A 45˚ line have been included to indicate the points at which C = Y. Where the consumption
function intersects the 45˚ line, real domestic income equals planned consumption and so
consumers will consume all of their income.

It can be seen that at very low incomes, C > Y, i.e, there is dissavings (one has to borrow
or spend more of their savings) while at high levels of income, C < Y there is savings.

The Keynesian consumption function

Keynesians believe that the consumption function can be written as the following equation:
C = a + bY
Where:

C - Consumption expenditure
a - Autonomous consumption
b – marginal propensity to consume

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Consider the diagram below:

The Keynesian equation explained

Autonomous consumption (a)

This is the level of consumption that takes place when income is zero. If an individual’s
income falls to zero some of his/her consumption could be sustained by using savings. This
is what is referred to as dissavings.

Autonomous spending is therefore independent of disposable income, i.e, it does not

depends on the level of disposable income.

Marginal Propensity to Consume (MPC)- b

This is the change in consumption caused by a change in disposable income. The MPC is
the ratio of changes in consumption relative to changes in disposable income. It can be
calculated by:
Change in consumption or ∆C
Change in disposable income ∆Y

Consider the table below:

Year Consumption Disposable Marginal

Income Propensity
to
Consume,
MPC
1997 $2,700 $3,200
1998 3,000 3,600
1999 3,300 4,000
2000 3,600 4,400
2001 3,900 4,800
2002 4,200 5,200

The MPC is therefore the slope of the consumption function. Notice that the MPC is constant
at all levels of income.

An MPC of 0.75 means that for every additional $1 earned by a household 0.75c is
consumed.

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The Saving Function

Saving is the act of setting aside income by postponing consumption. When income is
received, a portion of it is paid in taxes. The balance is referred to as disposable income, as
it represents the amount which consumers have available for spending.

Thus savings is equal to disposable income (Y) minus consumption (C)

S=Y-C

The equation above implies that consumption and saving are inversely related, meaning
that at unchanged income, any increase in the level of consumption would lead to a fall in
the level of saving.

The Saving function illustrated

S = -a + s Yd

In this equation the intercept is e, the autonomous level of Savings. With savings, it is quite
likely that “a” will be negative, which indicates that when Disposable Income is zero,
Savings on average are negative. The slope of the savings function is “s,” and it represents
the Marginal Propensity to Save—the increase in Savings that would be expected from any
increase in Disposable Income.

The function shows that there is a positive relationship between saving and the level of
disposable income, implying that as income increases so too does the level of saving.
The gradient of the savings function shows the marginal propensity to save.

Marginal Propensity to Save (MPS)

This is the ratio of change in saving to the change in disposable income. It is calculated as:
Change in savings or ∆C
Change in disposable income ∆Y

MPS = 1- MPC
MPS + MPC = 1

Example: If the MPC is 0.75 then the mps is 1 – 0.75 = 0.25. This means that for every
additional $1 earned by a household, 25c is saved.

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The Saving Function and the Consumption Function combined

• The figure shows that saving is positively related to the level of disposable income.
This implies that as income increases, so too does the level of saving.

• Total consumption exceeds income causing dissaving.

• When Y = 0, autonomous consumption is given by ‘a’ which is equal to the

magnitude of dissavings ‘-a’.

• Where C = Y, saving is 0 because all of the income is spent on consumption.

Average Propensity to Consume

This is the ratio of aggregate consumption to national income. It is the proportion of income
devoted to consumption.
APC = C
Y

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When:

C > Y, APC > 1

C < Y, APC < 1

C = Y, APC = 1

Consider the diagram:

Assuming a constant MPC, C = Y at point ‘s’ with an income level of Y*. APC = 1.

At point ‘x’, C > Y. The APC>1, this implies that consumers are dissaving. They are
spending what they do not have.

At point ‘v’, C < Y. The APC <1, at this point consumers are saving.

Average Propensity to Save

This is the ratio of aggregate consumption to national income. It is the proportion of income
devoted to consumption.
APC = S
Y

APS = 1- APC
APC = 1- APC

Consider the tables below:

Y C S APC MPC MPS

3000 3400
4000 4200
5000 5000
6000 5800
7000 6600
8000 7400
9000 8200

ACTIVITY

Y C APC MPC
0 20
25 35
50 50
75 60
100 80

Points:

When Y=0, consumer spending is equal to 20 which is autonomous consumption.

When Y=0, APC is undefined.

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As Y increases from 0 to 25, consumption rises from its autonomous level of 20 to 35. This
is said to be induced consumption.

As income increases the APC gradually declines which implies that at higher levels of income
a smaller proportion is devoted towards consumption.

The MPC is constant at 0.6 at all levels of income. This is because the consumption function
is linear and thus has a constant gradient. If there is a change in the MPC, it will cause the
consumption line to pivot.

Example

Let’s do an example using data for a hypothetical economy. The data is presented in the
table below. From this data I will graph both the Consumption Function and the Savings
Function and calculate the MPC and the MPS. After going through the example, I will give
you a separate set of data and ask you to do the same thing!

Disposable Income Consumption MPC Savings MPS

$15,000 $15,250 0.75 -$250 0.25
$16,000 $16,000 0.75 $0 0.25
$17,000 $16,750 0.75 $250 0.25
$18,000 $17,500 0.75 $500 0.25
$19,000 $18,250 0.75 $750 0.25
$20,000 $19,000 0.75 $1,000 0.25

Notice that as you move from an income of 15,000 to an income of 16,000, consumption
goes from 15,250 to 16,000 and savings goes from -250 to 0. The MPC and MPS are
therefore:

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MPC = ∆C/∆Yd = 750/1000 = 0.75

MPS = ∆S/∆Yd = 250/1000 = 0.25

Since the Consumption Function and the Savings Function are both straight lines in this
example, and since the slope of a straight line is constant between any two points on the
line, it will be easy for you to verify that the MPC and the MPS are the same between any
two points on the line. You can also see that that MPC + MPS =1 as was stated earlier.

Think About It: Calculating MPC and MPS

Graph the Consumption Function and the Savings Function for the data provided in the table
below. Also calculate the MPC and the MPS in this example. Calculate also the APC and APS.
Disposable Income Consumption Savings MPC MPS
$4,575 $4,647 -$72
$4,755 $4,791 -$36
$4,935 $4,935 $0
$5,115 $5,079 $36
$5,295 $5,223 $72
$5,475 $5,367 $108
$5,655 $5,511 $144
$5,835 $5,655 $180
$6,015 $5,799 $216
$6,195 $5,943 $252

NON INCOME DETERMINANTS OF CONSUMPTION

Notice that when we graph the Consumption Function, Consumption is measured on the
vertical axis and disposable income is measured on the horizontal axis. As disposable
income goes up, consumption goes up and this is shown by movement along a single
consumption function. But there are other things that influence consumption besides
disposable income. What if one of these non-income determinants of consumption changes?
Since they are not measured on either axis, we should note that a change in a non-
income determinant of consumption will shift the entire consumption function not
merely move you along a fixed consumption function. Let’s look at several of these
non-income determinants of consumption and savings:

1. Wealth—In economics wealth and income are two separate variables. A simple
example will illustrate the difference. Let’s say that you have a job earning $50,000
a year. If your great aunt Maude dies and leaves you $100,000 in an inheritance,
your income is still $50,000 a year, but your wealth has just gone up. The same
could be said about sudden increases in the value of a piece of art that you own, the
discovery of oil on your property, or increases in the value of your stock portfolio.
None of these occurrences increases your income, but they all increase your wealth.
An increase in wealth will increase your consumption even at the same
income level, and can be illustrated by an upward shift in both the
Consumption Function and the Savings Function. Obviously, a decrease in
wealth will have the opposite effect.

2. Expectations—There are times when consumers adjust their spending, based not
on their actual income but rather on their expectations of future changes in their
income. Changes in expectations will cause a shift in the curve, because
consumption has changed without an actual chance in income. For example, if you
think your income is going to go up in the future, you may consume more today.
Not that we suggest this as a wise course of action, but it has been observed that
some college seniors start to spend more once they have secured a job, even
though that job (and its attendant income) will not start for a month or two. This
behavior would be illustrated by an upward shift in the consumption function
showing that your consumption has increased even though your actual disposable
income has not. Likewise, if for some reason you were pessimistic about your
future income (rumors floating around the company that layoffs were eminent) you

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 might decrease your consumption, even though your actual current income had not
changed.

3. Consumer Indebtedness—Consumers adjust their consumption to levels of

indebtedness as well. We observe in the aggregate economy that when
indebtedness goes up, consumption falls and savings rise. There is a level of debt
beyond which consumers feel uncomfortable with additional spending. Even if
income has stayed the same, if too much debt accumulates, consumers will start to
spend less and pay off debt. This is illustrated by a downward shift in the
Consumption Function and an upward shift in the Savings Function (remember that
paying off debt is the same thing as increasing savings). The opposite is also true.
At low levels of debt people will consume more and save less.

4. Interest Rate

An increase in the interest rate will discourage consumption and encourage

savings. This will reduce consumption. A decrease in interest rate will increase
consumption.

5. Taxation

As the level of direct taxes fall, the disposable level of income for consumers will
increase which will hence more money to spend on consumer goods. An increase in
taxes will lower disposable income and decrease consumption.

ALL OF THE ABOVE WILL EITHER SHIFT THE CONSUMPTION FUNCTION UPWARDS
OR DOWNWARDS. (The savings function will be affected in the reverse order)

Income is the only determinant that will cause a movement along the consumption line.

Key assumptions of the Keynesian Consumption Function

1. When income is zero, APC is ∞ due to autonomous consumption. The consumption

function therefore the vertical axis above the origin.
2. MPC is less than 1, since as income increases, not all of the increases is devoted is
devoted to consumption.
3. MPC is assumed to be constant which means that as income increases, the
proportion of increase which is devoted to consumption remains uniform. A fixed
MPC implies that the consumption function has a constant slope which is a straight
line.
4. APC declines continuously, as income increases. This means, the greater the level of
income of a household, the smaller the proportion devoted to consumption.

THE DETERMINATION OF NATIONAL INCOME USING THE

WITHDRAWAL/INJECTION APPROACH

Recall the two sector model circular flow of income.

Income = expenditure
Withdrawals = injections

Deriving the injection function

1. Investment Function

2. Export Function

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 3. Government spending Function

Injection Function

Each component is not affected by the level of national income. This implies
that they are autonomous.

Deriving the withdrawal function

1. Savings Function

2. Taxation Function

3. Import Function

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The withdrawal function

The diagram above represents the withdrawals function, which is upward sloping, as
withdrawals are said to be induced by income. That is, withdrawals increase with the
level of income. As a result, if income increases, the level of withdrawals follows suit,
whilst if income declines, the level of withdrawals is reduced.

THE WITHDRAWAL INJECTION APPROACH TO DERIVE NATIONAL INCOME

This approach shows that equilibrium occurs when W=J. J have a positive effect on
national income while W have a negative effect.

If J>W then there is a tendency for national income to increase. This is because there is
a net injection into the circular flow of income which will increase the level of
expenditure in the economy. As a result, aggregate expenditure would exceed the level
of output in the economy (AE>Y). The extra aggregate demand will encourage firms to
expand production which leads to the employment of more labour. This means that
more income would be circulating in the economy prompting greater expenditure as well
which will lead to an increase in savings, imports and taxes (leakages). This process will
continue indefinitely where the continuous rise in income leads to continuing increases in
leakages until it matches the level of injections. The economy is now back at equilibrium
where W=J.

If W>J then there is a tendency for national income to fall. This is because there is a net
withdrawal from the circular flow of income which would cause the level of aggregate
expenditure in the economy to fall. As a result, the level of aggregate expenditure will
fall short of the output produced (AE<Y). This would contribute to an overall surplus of
unsold goods and services. This build-up of inventories cause prices to decrease which
forces firms to cut back on production. As a result, the overall amount of factors of
production employed declines. This results in the level of income in the economy falling.
This then leads to a reduction in savings, taxes and imports. This process will continue
until the level of withdrawals matches the injection. The economy is now back at
equilibrium where W=J.

THE MULTIPLIER
The multiplier effect

An initial change in aggregate demand can have a much greater final impact on the level of
equilibrium national income. This is known as the multiplier effect.

Definition:
This is the number of times a rise in national income exceeds the rise in injection demand
that caused it.
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It is the ratio of the change in equilibrium GDP (Y) divided by the original change in spending
that causes the change in GDP

Every time there is an injection of new demand into the circular flow there is likely to be a
multiplier effect. This is because an injection of extra income leads to more spending, which
creates more income, and so on. The multiplier effect refers to the increase in final income
arising from any new injection of spending.

The size of the multiplier depends upon household’s marginal decisions to spend, called the
marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps).

It is important to remember that when income is spent, this spending becomes someone else’s
income, and so on. Marginal propensities show the proportion of extra income allocated to
particular activities such as investment or consumption.

The corner stone of the multiplier is therefore the MPC.

CLASS ACTIVITY- Class Economy

What is a simple definition of the multiplier?

It is the number of times a rise in national income exceeds the rise in injections of demand that
caused it

Examples of the multiplier effect at work

• Consider a £300 million increase in capital investment– for example created when an
overseas company decides to build a new production plant in the UK

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 • This may set off a chain reaction of increases in expenditures. Firms who produce the
capital goods and construction businesses who win contracts to build the new factory
will see an increase in their incomes and profits
• If they and their employees in turn, collectively spend about 3/5 of that additional
income, then £180m will be added to the incomes of others.

At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services realize
an increase in their incomes, of which they in turn spend 60% on even more goods and services.

The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).

Each time, the extra spending and income is a fraction of the previous addition to the circular
flow.

GNERAL FORMULA FOR MULTIPLIER

The following general formula to calculate the multiplier uses marginal propensities, as follows:

1/1-mpc

Hence, if consumers spend 0.8 and save 0.2 of every £1 of extra income, the multiplier will be:

1/1-0.8
= 1/0.2
=5

Hence, the multiplier is 5, which means that every £1 of new income generates £5 of extra
income.

Example:

Assume that, without taxes, the consumption schedule of an economy is as shown below:

GDP, Billions Consumption, Billions

100 120
200 200
300 280
400 360
500 440
600 520
700 600

a. Graph this consumption schedule and note the size of the MPC.
b. What will be the impact on national income if the government spends 500 billion in the
economy?

DERIVING THE MULTIPLIER

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Y = C + I + G + X-M

Practice Question

The following information represents the aggregate expenditure (AE) for an economy.

Consumption (C) = 100-0.9Y

Investment (I)= 200
Government Spending (G) = 50

i. Calculate the equilibrium level of income

ii. Calculate the size of the multiplier

Multiplier Open Economy

As well as calculating the multiplier in terms of how extra income gets spent, we can
also measure the multiplier in terms of how much of the extra income goes in
savings, and other withdrawals. A full ‘open’ economy has all sectors, and therefore,
three withdrawals – savings, taxation and imports.

This is indicated by the marginal propensity to save (mps) plus the extra income
going to the government - the marginal tax rate (mtr) plus the amount going abroad
– the marginal propensity to import (mpm).

By adding up all the withdrawals we get the marginal propensity to withdraw (mpw).
The multiplier can now be calculated by the following general equation:

1/1- mpw

M = 1/mps + mrt + mpm

Calculating the value of the multiplier

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The formal calculation for the value of the multiplier is

Multiplier = 1 / (sum of the propensity to save + tax + import)

Therefore if there is an initial injection of demand of say £400m and

• The marginal propensity to save = 0.2

• The marginal rate of tax on income = 0.2
• The marginal propensity to import goods and services is 0.3

Then the value of national income multiplier = (1/0.7) = 1.43

An initial change of demand of £400m might lead to a final rise in GDP of 1.43 x £400m =
£572m

If

• The marginal propensity to save = 0.1

• The marginal rate of tax on income = 0.2
• The marginal propensity to import goods and services is 0.2

The value of the multiplier = 1/0.5 = 2 – the same initial change in aggregate demand will lead
to a bigger final change in the equilibrium level of national income.

The value of the multiplier depends on

• Propensity to import
• Propensity to save
• Propensity to tax
• Amount of spare capacity
• Avoiding crowding out

• 1.The higher is the propensity to consume domestically produced goods and services,
the greater is the multiplier effect. The government can influence the size of the
multiplier through changes in direct taxes. For example, a cut in the rate of income tax
will increase the amount of extra income that can be spent on further goods and
services
• 2.Another factor affecting the size of the multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend their money on imports, this demand is
not passed on in the form of fresh spending on domestically produced output. It leaks
away from the circular flow of income and spending, reducing the size of the multiplier.
• 3.The multiplier process also requires that there is sufficient spare capacity for extra
output to be produced. If short-run aggregate supply is inelastic, the full multiplier
effect is unlikely to occur, because increases in AD will lead to higher prices rather than
a full increase in real national output. In contrast, when SRAS is perfectly elastic a rise in
aggregate demand causes a large increase in national output.
• 4.Crowding out – this is where (for example) increased government spending or lower
taxes can lead to a rise in government borrowing and/or inflation which causes interest
rates to rise and has the effect of slowing down economic activity.

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In short – the multiplier effect will be larger when

1. The propensity to spend extra income on domestic goods and services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend gains in income)
5. Businesses in the economy have the capacity to expand production to meet increases in
demand

Time lags and the multiplier effect

• It is important to remember that the multiplier effect will take time to come into full
effect
• A good example is the fiscal stimulus introduced into the US economy by the Obama
government. They have set aside many billions of dollars of extra spending on
infrastructure spending but these capital projects can take years to be completed.
Delays in sourcing raw materials, components and finding sufficient skilled labour can
limit the initial impact of the spending projects.

The multiplier effect in an open economy

As well as calculating the multiplier in terms of how extra income gets spent, we can also
measure the multiplier in terms of how much of the extra income goes in savings, and other
withdrawals. A full ‘open’ economy has all sectors, and therefore, three withdrawals – savings,
taxation and imports.

This is indicated by the marginal propensity to save (mps) plus the extra income going to the
government - the marginal tax rate (mtr) plus the amount going abroad – the marginal
propensity to import (mpm).

By adding up all the withdrawals we get the marginal propensity to withdraw (mpw). The
multiplier can now be calculated by the following general equation:

1/1- mpw
Applying the ‘multiplier effect’

The multiplier concept can be used any situation where there is a new injection into an
economy. Examples of such situations include:

1. When the government funds building of a new motorway

2. When there is an increase in exports abroad
3. When there is a reduction in interest rates or tax rates, or when the exchange rate falls.

Note: In order to find the multiplier given a change in investment or government spending, the
formula is :
M = change in Y/ change in I OR M = change in Y/change in G

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INCOME AND EXPENDITURE APPROACH TO NATIONAL INCOME

The Keynesian Cross Diagram

The Keynesian cross diagram demonstrates the relationship between aggregate

expenditure.

Diagram:

The Keynesian cross diagram demonstrates the relationship between aggregate demand
(shown on the vertical axis) and aggregate supply (shown on the horizontal axis, measured
by output).

In the Keynesian cross diagram (or 45-degree line diagram), a desired total spending (or
aggregate expenditure, or "aggregate demand") curve (shown in blue) is drawn as a rising
line since consumers will have a larger demand with a rise in disposable income, which
increases with total national output. This increase is due to the positive relationship between
consumption and consumers' disposable income in the consumption function.

Aggregate demand may also rise due to increases in investment (due to the accelerator
effect), while this rise is reduced if imports and tax revenues rise with income.

Equilibrium in this diagram occurs where total demand, AD, equals the total amount of
national output, Y, (which corresponds to total national income or production). Here, total
demand equals total supply.

In the diagram, the equilibrium level of output and demand is determined where this
desired spending curve intersects a line that represents the equality of total income and
output (AD=Y). The intersection gives the equilibrium output, Y

Shifts in AE line

If any of the components of aggregate demand (C + I + G+ X-M) rises at each level of

income, for example business confidence becomes more optimistic about future profitability,
that shift the entire AD curve upward.

Determination of equilibrium

Disequilibrium can occur with regards to the level of NY when the total level of planed
expenditure is not equal to the level of planned output.

Note that the variable Y refers to both aggregate output and aggregate income. When
output increases, additional income is generated.

1. Disequilibrium: Planned expenditure exceeds planned output (E > Y)

In this case the overall demand for goods and services will not be met by the overall
level of output produced. Firms face a decline in their inventories or a shortage and
as a consequence price will rise. Firms will then be encouraged to produce more
output which generates more income which generates more income for the owners if
the factors of production and as a result the overall income rise until it match
expenditure. Equilibrium would then be achieved.

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 2. Disequilibrium: Planned expenditure is less than planned output (E<Y)

In this case the overall level of output exceeds overall demand. This will then create
a surplus of rising inventory of unsold goods which will compel firms to lower prices.
As a consequence firms would be force to cut back on production to acknowledge
the lower level of demand in an attempt to avoid the built up of inventory. This
means that less factor inputs will be employed which therefore means less income
for households, this will continue until income falls sufficiently to match expenditure.

INFLATIONARY GAP AND DEFLATIONARY GAP

• INFLATIONARY GAP (Positive output gap)

Inflationary gap exists when the economy is at equilibrium beyond the full employment level
of output. At point X, a situation is created where people are trying to buy more goods and
services than what the economy can actually produce. This excess demand is what will
create inflationary pressures in the economy.

How to correct an inflationary gap?

The government can correct an inflationary gap by instituting contractionary monetary and
fiscal policy (to reduce spending). This would mean to raise interest rates, reduce the
money supply or lower government spending or increase taxation. This action will then shift
the aggregate expenditure downwards until the gap is closed.

• DEFLATIONARY or RECESSIONARY GAP (Negative output gap)

Deflationary gap exists when the economy is at equilibrium below the full employment level
of output. At point X, a situation is created where there is a lot of spare capacity in the
economy. The level of spending is low hence aggregate expenditure is low. Firms therefore
produce less which results in resources being idle. The low demand will create a surplus and
forces firms to lower prices which will result in lower output.

How to correct a deflationary gap?

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The government can correct a deflationary gap by instituting expansionary monetary and
fiscal policy (to increase spending). This would mean to lower interest rates, increase the
money supply or increase government spending or decrease taxation. This action will then
shift the aggregate expenditure upwards until the gap is closed.

A TASTE OF REAL MACROECONOMIC ANALYSIS……COLLEGE

ECONOMICS - CLASS ANALYSIS

National Income and The Foreign Trade Multiplier

Article Shared by Subho Mukherjee

National Income and The Foreign Trade Multiplier!
The Import Function:
In an open economy consumers of a country also spend some income on imported goods.

The imports of a country depend on its level of income. The higher the level of income, the
prices of imported goods and tastes of consumers remaining the same, the greater will be
its imports.

ADVERTISEMENTS:

The relationship between imports and level of income of a country is called the
import function and is written as:
M = f(Y)

ADVERTISEMENTS:

where M stands for imports and Y for income of a country.

We have shown the import function in Fig. 24.1 where on the X-axis the level of national
income and on the Y-axis imports of a country are measured. It will be seen that even at
zero national income some imports are undertaken by exporting some capital accumulated
in the past or by borrowing from abroad.

ADVERTISEMENTS:

There are two concepts of propensity to import which should be understood. First, average
propensity to import is defined as the proportion or percentage of national income spent on
imports, that is, it is rupee value of imports divided by national income or M/Y.

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Large countries such as the U.S.A., Russia and India have low average propensity to import
and small countries such as Great Britain and Holland have high average propensity to
import. The average propensity to import in India is between 0.02 and 0.03.

More important concept is the marginal propensity to import. The marginal propensity to
import measures the change in import as a result of increase in national incomes and is
algebraically expressed as ΔM/ΔY where ΔM is the change in value of imports and ΔY is the
increase in national income. If imports increase by Rs. 3 when national income rises by Rs.
100, the marginal propensity to import (ΔM/ΔI) will be equal to 3/100 = 0.03 or 3 per cent.
If increase in income by Rs. 100 leads to the increase in imports by Rs. 10, the marginal
propensity to imports is 10/100 = 0.1 or 10 per cent.

The Foreign Trade Multiplier in an Open Economy:

In a closed economy equilibrium level of national income is determined at the level where
intended saving equals intended investment (S = I). Saving represents leakage or
withdrawal of some money from the income flow, while investment is the injection of some
money into the income stream.

The level of national income is in equilibrium (that is, circular flow of income is constant)
when leakage from the income stream in the form of savings is equal to the injection of
investment expenditure. In an open economy, the role of foreign trade, that is, exports and
imports of a country are also to be considered. Imports by consumers of a country
represent the expenditure on imported goods by the residents of the country and leads to
the leakage of some income from domestic economy.

Therefore, in addition to saving, imports are other form of leakage that occur in an open
economy. On the other hand, exports represent expenditure by the people of foreign
countries on the goods produced in the domestic economy and are, like domestic
investment, injection into the income stream of an open economy.

Therefore, equilibrium level of national income in an open economy is determined at the

level at which total leakage, that is, savings plus imports (S + M) equal total injection, that
is, domestic investment plus exports (I + X) into the income stream.

Thus, in an open economy, national income is in equilibrium at the level at which

S+M=I+X

When a change in any of the above four variables occurs, then the change on the left side of
the above equation must equal the change on the right side if the new equilibrium is to be
achieved.

Hence

ΔS + ΔM = ΔI + ΔX …(1)

Now, change in saving, ΔS = s. ΔY

Where s = marginal propensity to save and

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ΔY= change in national income.

Likewise, change in imports, ΔM = m. ΔY

where m = marginal propensity to import.

Thus, foreign trade multiplier is equal to the reciprocal of marginal propensity to save (s)
plus marginal propensity to import (m). It is evident that smaller the leaks, that is, smaller
the values of marginal propensity to save (s) and marginal propensity to import (m) the
greater the value of foreign trade multiplier. Let us given an example. If s = 0.2 and m =
0.2, then

Graphic Representation of Foreign Trade Multiplier:

The foreign trade multiplier has been graphically illustrated in Fig. 24.2 where S + M is the
saving plus import function curve and X0 is the export curve which is constant as it has been
assumed to be an autonomous variable, that is, independent of the level of income. To
simplify our analysis we assume that there is no investment, equilibrium level of national
income will therefore be determined by consumption (saving) and exports.
Initially, the economy is in equilibrium at level of income Y0 where S + M=X0, investment
being zero. Suppose there is autonomous increase in exports so that export curve shifts
upward from X0 to X1. It will be seen from Fig. 24.2 that equilibrium income increases to Y1.

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Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to Y1 – Y0 which
is much greater than change in exports (ΔX). The expression ΔY/ΔX represents the foreign
trade multiplier whose value depends on the slope of saving-import function curve S+ M
which is equal to the reciprocal of the sum of marginal propensity to save and marginal
propensity to import (1/s + m).
How the Foreign Trade Multiplier Works?
The foreign trade multiplier works in the same way as Keynes’ investment multiplier. When
there is increase in exports, it will cause the increase in income of the exporters and those
employed in the export industries. They will save some of the increase in their incomes and
will spend a good part of the increases in their incomes on consumer goods, both domestic
and imported ones.

While savings do not generate further income and represent leakage from the income
stream, expenditure on imports leads to the increase in the incomes of the foreign countries
from which goods are imported. Thus expenditure on imports also represents a leakage
from the income stream as far as domestic economy is concerned.

But the increased expenditure on domestic goods as a result of increase in exports will go
on increasing incomes in various successive rounds of spending till the multiplier fully works
itself out.

It may be noted that increase in exports of a country can occur due to several reasons.
There may be change in tastes or demand of the people of foreign countries for goods of a
country. To begin with, the exporters may meet the demand for exported goods by selling
their inventories and enjoy higher incomes.

But in the next periods, they will make efforts to increase the production of exported goods
and employ more workers. This will generate new income and employment in the export
industries. But the working of multiplier does not stop here.

Those employed in export industries will spend a good part of their increased incomes on
goods produced by other industries and in this way increases in income, production and
employment will spread in the whole of the domestic economy.

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The Foreign Trade Multiplier: With both Exports and Domestic Investment:
In our foregoing analysis we have explained the multiplier effect of autonomous increase in
exports assuming that there is no domestic investment. We will now further elaborate the
foreign trade multiplier by considering both exports and domestic investment.

In an open economy when there is positive investment the level of equilibrium in national
income is reached when sum of domestic investment and net exports equals saving.

Thus, in an open economy the condition for the equilibrium level of national
income is:
Id + Xn = S …(1)
where Id is domestic investment, Xn is net exports and S is the saving
Net exports (Xn) is the net of exports over imports, that is, Xn = X – M
Substituting X – M for Xn in equation (1) we get
Id + (X – M) = S
or Id + X = S + M
In the case when there is positive domestic investment the determination of the equilibrium
level of national income is graphically shown in Fig. 24.3. The curve Id represents
autonomous domestic investment which remains constant. S is the saving function curve
showing that saving is the increasing function of income.
Over the domestic investment curve (Id) we have added the exports (X) of the economy to
get Id + X curve. To the saving function curve we have added the import function curve to
obtain the aggregate of saving and import functions curve (S + M).
It will be observed from Fig. 24.3. That Id + X equals S+M at point E and thus the
equilibrium level of national income Y0 is determined. Note that at Y0 level of income saving
(S) and domestic investment (Id) are also equal. Thus, at equilibrium income Y0:
Id + X = S + M
and Id = S
Therefore, at Y0 equilibrium income:
X=M

The equality of exports (X) with imports (M) implies that there is equilibrium in the balance
on the current account. However, it is important to note that it is not necessary that at
equilibrium level of national income exports (X) equal imports (M).

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This equilibrium in the current account balance along with equilibrium of saving and
domestic investment occurs only when exports are equal to imports at the equilibrium level
of income determined by the equality of saving and domestic investment.

In Fig. 24.3. at equilibrium income Y0 at which saving equals domestic investment, imports
are equal to DE. If exports happen to be equal to DE, the equilibrium in the current account
balance will also occur. However, this is not necessary because exports may be greater or
less than the imports DE.
Suppose autonomous exports increase so that the investment – exports curve shifts above
to Id + X1 as shown in Figure 24.4. This new Id + X1curve intersects S + M curve at point H
and as a result equilibrium national income Y1 is determined. It will be seen from Fig. 24.4
that at national income Y1 the volume of exports is LH which exceeds the imports CH by LC
amount.
Note that LC is the amount by which saving exceeds domestic investment. It is this excess
of saving over domestic investment that maintain the equation ld + X = S + M despite
exports (X) being not equal to imports (M). Thus, in this case there is surplus in the balance
of payments on current account.

The opposite case can also occur when exports fall below ED. If the exports fall and the in-
vestment-export curve shifts to ld + X2 (Fig. 24.5), the new equilibrium is reached at income
level Y2 at which Id+X2= S + M. In this equilibrium situation imports are equal to VT which
exceeds exports (X2) which are equal to KT.
Thus, though the open economy is in equilibrium as ld + X2 = S + M at income level Y2,
there exists import surplus or deficit in current account balance which again implies that
there is disequilibrium in the balance of payment on the current count.
However, in this case of import surplus (i.e. deficit in current account balance), domestic
investment must exceed domestic saving by an equal amount so as to maintain the equality
of Id + X with S + M. This is possible only if a country borrows from abroad to keep
investment greater than domestic savings.

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The above analysis shows that while the open economy as a whole may be in equilibrium, it
is not necessary that balance of payment (on current account) will also be in equilibrium.

Increase in Imports: The Reverse Working of Foreign Trade Multiplier:

Whereas increase in exports has an expansionary effect on national income, the increase in
imports will have opposite effect on national income. Imports will bring about contraction in
national income. Further, the effect of increase in imports on national income will not be
equal to the increase in imports but will have a multiplier effect in reducing national income.

There can be several reasons for the increase in imports of a country. An important reason
for the increase in imports is the change in tastes or preferences of the people. The people
of a country may have started preferring the imported goods as compared to Swadeshi
(home produced) goods.

The reduction in import duties on the imports and thus making them cheaper may be
another reason for the increase in imports a country. The contractionary effect of increase in
imports on the income and employment in a country is illustrated in Fig. 24.6. To simplify
our analysis we have assumed that there are no net savings and investment.

In this Fig. 24.6 the export curve is a horizontal straight line since exports are assumed to
be autonomous of changes in national income. The curve M represents the import function
curve which slopes upward showing that it changes with national income.

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The two curves X and M intersect at point E and determine Y0equilibrium level of national
income. Now suppose that there is increase in imports (ΔM = ET), say due to the change in
preferences for foreign goods, and as a result import function curve shifts above to the
position M1, the export curve X remaining unchanged.
It will seen from Fig. 24.6 that new import function curve M1 and export curve X intersect at
point E1 and as result the equilibrium level of income falls to Y1. Note that reduction in
income is greater than the increase in imports; ΔY is much greater than ΔM. This is due to
the working of foreign trade multiplier which in the present case works to reduce income.
When the consumers buy more foreign goods and less domestically produced goods, the
demand for domestically produced goods decreases which result in fall in incomes and
employment of those engaged in the domestic industries. These reduced incomes further
reduce the expenditure on the purchase of other home-produced goods and so on. The
reverse process of contraction of income, production and employment goes on till the
multiplier fully works itself out.

It is important to note that initial attempt to increase imports has not finally resulted in any
increase in imports. Imports Y0E at the initial equilibrium income Y0 are equal to imports
Y1E1 in the new equilibrium at the much lower level of income. This is another paradox
which is described as import paradox.
What has actually happened is that the increase in imports and consequent upward shift in
the import function leads to a large contraction in income through the reverse working of
foreign trade multiplier so that in the new equilibrium at a much lower income, less is
imported. This is generally referred to as income effect.

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